2 Illegal flows in India’s BOP accounts
Their components and impact on the economy
Introduction
During colonial rule, India was subject to drain of wealth and lost a considerable amount of its savings. Consequently, it faced a shortage of capital for essential development. Its social and physical infrastructure was woefully inadequate compared to what the colonial power managed to accumulate (Kumar 2013). With independence in 1947, it was expected that this loss of savings would come to an end. Instead, it changed its form. One of the important forms through which the country has been losing savings in the post-independence period is flight of capital: that is, capital going out of the country illegally. Its magnitude has been growing over time and is harming the nation in a wide variety of ways (Kumar 1999). In this chapter, the macroeconomic aspects of illegal flows and flight of capital, the activities associated with them and their impact on the Indian economy are analysed.
Illegal flows have a link with the balance-of-payment (BOP) account of a nation. In the literature, illegal flows in economies’ BOP accounts are ignored. For instance, such flows result in capital movements, even though the economy may not formally have capital-account convertibility. In effect, while the economy may be formally closed, in actuality it is not; therefore, there are policy implications, such as policy failure. This has been true in the case of the Indian economy, where analysts do not account for the illegal flows since they are ignored in the official data.
The nation’s exports and imports of goods and services are misdeclared in order to siphon off capital, and this impacts the trade and current account balances in BOP (Kumar 1999; Baker 2005). The implication is that the amount not captured in BOP may be kept abroad as savings, and that constitutes a part of the total illegal flows of capital. It also occurs in other forms, such as through havala (an illegal banking channel).
If the illegal flows were small in relation to the extent of recorded trade or legal capital flows into (or out of) the country, their macroeconomic impact would be small and it could be neglected. However, indications are that these figures are large and, therefore, need to be taken into account in any macroeconomic analysis of the Indian economy.
Illegal flows of capital and flight of capital
Definitional aspect
The illegal flows contained in BOP accounts are made up of illegal flows of financial assets, capital and goods and services. The terms used are illegal flows, illicit financial flows and flight of capital. In the literature, there is a lack of clarity in the use of these terms, and they tend to be used synonymously. For instance, Kar (2001: 47) states: ‘Economists have used various models to estimate illicit financial flows, or illegal capital flight’. This statement indicates that the terms ‘illicit financial flows’ and ‘illegal capital flight’ are taken to mean the same thing.
In reality, the illegal flows are much larger than the illicit financial flows, which leave out illegal flows of goods and services. Gross flight of capital needs to be distinguished from flight of capital, which implies the net amount of capital leaving a country. The former term would only include the amount of capital leaving the country, without subtracting the amount of capital returning back to the country. The Actual BOP may be written as the sum of official BOP and the BOP on account of illegal flows.
Unfortunately, most analysts only refer to the first term, since that is what the official data presents, and leave out the second term. This makes the analysis partial and is the source of many errors in analysis of economies’ external sectors. Data on the second term is hard to find and has to be pieced together from scattered data, as is done by Kumar (1999) and Baker (2005). In this chapter, an attempt is made to analytically separate the four kinds of illegal flows referred to in the literature and list the various elements that need to be included in the illegal flows affecting an economy.
Estimates of illegal financial flows and flight of capital: a critique
There have been studies of illegal flows in BOP for some time, but of late, interest in the subject has increased and a number of studies have been carried out. Sen (1975) provided a theoretical understanding of smuggling and its links with the Indian economy. Nayak (1977) analysed partner-country data to estimate the extent of flight of capital in the 1970s. Zdanowicz et al. (1996) estimated loss of capital in trade between India and the United States. Kumar (1999) gave some estimates of havala and trade misinvoicing for 1990–1.
Amongst the recent estimates of flight of capital since independence, the figure of 1.4 trillion USD lying in Swiss banks is widely quoted. This information is attributed to the Swiss Bankers’ Association Report for 2006; however, the report does not mention any such figure. It was also said that the amount of money held in Swiss banks by Indians was larger than that held by members of all other nationalities put together. This also seems to be a doubtful proposition, since huge sums have been going out of various other countries for a long time – especially from the former Soviet republics since the break-up of the Soviet Union.
Further, on its website, the Tax Justice Network (TJN, online) lists 45 tax havens in the world (some say that the number is 77) in which illegal funds are deposited. Switzerland is the best-known and possibly the biggest of these, but to get a total figure for illegal flows from India, one must combine the funds deposited in all tax havens, not just in Swiss banks. Further, if the amount deposited in Switzerland alone is of the order of 1.4 trillion USD, the total sum likely to be held abroad could be a multiple of this amount – such a large figure seems implausible. Finally, according to the Swiss banking authorities, the figure of 1.4 trillion USD is larger than the amount of deposits in the country’s banks.
The situation becomes even more complicated, since it is generally not known who is depositing the funds in a Swiss bank. Further, while some inexperienced individuals or economic entities transferring illegal funds out may do so in their own name, this is not the usual practice, as will be discussed below. Funds are usually moved out via shell companies through layering, so that the money in a Swiss bank account may be deposited via a company registered in some tax haven. Thus, the money in the account would not appear to have originated from India but from some other country, and may not be in an Indian’s name, but rather that of a company, whose official owner may be some other nationality.
According to an estimate given by Baba Ramdev at various meetings and press conferences in 2011 and 2012, funds held by Indians in foreign accounts may be as high as 8–9 trillion USD. These calculations are based on a monetarist approach which compares the amount of high-denomination currency in circulation in the country with the same figure for other big economies in order to estimate the excess of such notes in circulation. This is akin to Feige’s (1979) monetarist method, which was used by Gupta and Gupta (1982) to estimate the size of India’s black economy in the 1970s. These were critiqued in Kumar (1999) on the grounds that these methods are definitionally lacking and ignore the differences in banking practices across countries. The figure also seems to be improbable since it is several times the size of the present official GDP and it is unlikely that such a large amount of Indian savings would be lying abroad, even if accumulated over more than six decades. Even if this figure refers to the total capital taken out and accumulated earnings on it, the sum is too large to be credible.
Kar (2011) has estimated that illicit financial flows or flight of capital from India in the sixty-two years since independence amount to 462 billion USD (this study will henceforth be referred to as DK). This figure is based on the recorded BOP and the World Bank Residual Model, along with the trade mispricing between India and the rest of the world obtained from the IMF’s Direction of Trade Statistics (DOTS). It also includes the interest that may have been earned on the capital taken out calculated at the US Treasury rate. There are several problems with this calculation (Kumar 2012).
First, as the author admits, this figure is a gross underestimate of the actual likely figure of outflow. ‘In sum, economic models cannot capture all illicit flows due to a variety of reasons and therefore significantly understate their volume’ (Kar 2011: 47).
As pointed out previously, it does not account for the export and import of services whose trade is large and where trade mispricing is easy. Second, it does not take into account various illegal activities due to which funds go abroad, such as havala, human trafficking, the narcotic drug trade and the arms trade. Third, the trade mispricing data relates to a limited number of countries for which the IMF collects information. Thus, the amount of trade mispricing is likely to be larger than that estimated. This figure needs to be corrected to account for the countries left out of the IMF data. Fourth, over the past 15 years, some funds previously taken out of the country have come back to India via ‘round tripping’, such as through the Mauritius route. Thus, the figure of gross outflow and interest earned on it is not the actual figure that may be lying abroad at any point of time. Fifth, interest income would not accrue on the sum brought back, hence we need to know the net amount held abroad. Sixth, from the funds taken out of the country, some part is saved and the rest is consumed – not all is saved. Money is spent on children’s education, buying luxury goods, expenditure on health and so on; thus, a return would not accrue on the entire sum taken out of the country illegally. Hence, combining these two points, it can be seen that the interest income on capital held abroad calculated by DK is in error. Seventh, illegal funds held abroad are mostly invested and usually yield a high return – much higher than the US Treasury rate, which is just a base rate for very secure investments. Hence the amount of earnings on the capital held abroad would be larger than that assumed in DK.
In summary, DK gives a very conservative estimate and does not tell us how much capital is currently lying abroad. It estimates the opportunity cost of the funds that have gone abroad illegally in the past 62 years. An implication is that the sum of money estimated by DK is not what can be brought back (as some wish to do), since the figure is hypothetical.
Links with the black economy in the country
Illegal flows from the country are linked to illegality in economic activities within the nation and, therefore, to the black economy. As the share of the black economy has grown (Kumar 1999), so have the illegal flows. From the black incomes, part is consumed and the balance is saved (as in the case of white income). From the incomes that are saved, part goes out through flight of capital. These outflows can be via havala (informal banking channels) or trade misinvoicing of goods and services. Smuggling may be considered to be an aspect of misinvoicing where the goods and/or services are not declared – the trade value is shown as zero. For instance, India imports gold and precious stones and exports jewellery; in all these cases, there is a degree of both mispricing and smuggling. They constitute a special case of smuggling because they are a near-money form. Smuggling of narcotics is another important component of the illegal flows.
Thus, to understand illegal flows in the BOP account, there is a need to appreciate the nature of the black economy in India. Black incomes are generated by committing an illegal action related to either legal or illegal activities. Typically, they are off-balance sheet profits (undeclared) which accrue to the capitalists. Wages are typically inflated to generate profits so that the real wage bill in the economy is less than that captured in the NAS. The result is that in the white economy, profits are understated and wages overstated. Bribes paid to officials are transfer incomes and therefore should not be counted in the GDP. However, they result in a redistribution of the black incomes from their primary generators to others. Similarly, capital gains in real estate and share markets are transfer incomes and should not be counted in the estimate (Kumar 1999).
The implication of the above aspects of the black economy is that the actual distribution of income as compared to the declared distribution is skewed in favour of profit earners. Since profit earners have larger incomes than wage earners, their savings propensity is also larger. Thus, as the black economy increases relative to the white economy, the savings propensity of the economy rises. Is black income generation then beneficial for the economy?
Unfortunately, the black economy lowers the overall economy’s investment level, because capital is wasted and its efficiency lowered by the black economy (Kumar 1999). It is shown that black investments go through seven channels, including unproductive ones and flight of capital. Flight of capital results in loss of capital for the domestic economy and generates employment and multipliers abroad, not in India. Thus, the investment and savings rates move in the opposite direction due to the existence of the black economy; this lowers the rate of economy growth in comparison with the potential rate of growth that could have been achieved in the absence of the black economy (Kumar 2005).
At a rough guess, 50 per cent of the black incomes are consumed and the balance saved. Of the amount saved, at a rough guess, 20 per cent leaves the country via illegal flows. In other words, of the black incomes generated annually, 10 per cent go abroad. This amount is comparable to the inflow of capital from abroad in the form of FDI, FII and non-resident flows.
The stock of savings held abroad is likely to be invested in various forms and would earn a return. This income ought to have come into the economy, but does not; this becomes a part of black income generation for the national economy. Thus, a part of the illegal flows is the return earned but not repatriated. How much would this be? That depends on the activities in which the illegal funds are deployed. Some of it may even be kept in secret accounts on which there may be no return; instead, there may even be a charge for holding the money. However, the bulk of the funds is likely to be invested in financial instruments, real estate, paintings, diamonds, businesses and so on, and would earn a substantial return.
Rates of return on illegal funds and the white economy
Those taking illegal funds out of the country do so for two reasons. First, the activity through which the funds are generated is illegal and the income cannot be declared. The second reason is that one wishes to earn a higher return than that available in India. The higher return is on account of taxes evaded, possibility of currency depreciation, reduced risk of detection and so on. In the second case, if a higher return is not available, it may be better to pay the tax and earn a (significant) return on the savings kept in the country.
For funds that are earned through criminality, the income cannot be declared in India without the danger of prosecution. Savings from such illegal incomes are also invested in illegal activities in the country and usually earn a large return (ri), often larger than what can be earned through legal incomes (rl). Thus, the expected return from funds taken out of the country would be
R – C ≥ ri – c.
Here R represents the average return on funds taken out of the country, including the possible depreciation of currency and lowering of the risk of detection. C is the cost of managing the funds as a fraction of the funds taken out of the country; ri is the rate of return available in the Indian economy for illegal activities, and would usually be higher than the profit available in business related to white incomes; and c is the cost of evasion expressed as a fraction of the illegal flows taken out, including the cost to be borne in case of detection of evasion.
In the second case, the funds may be invested either within the economy in legal activities, or within the economy in illegal activities, or taken abroad. Thus,
R – C ≥ ri – c ≥ rl. (1 – t) – Cc.
Here, t is the highest marginal tax rate in the country, rl is the rate of return on legal incomes and cc is the per-unit cost of conversion of black incomes from legal activities into white incomes.
It can be argued that when the funds taken out of the country are substantial, both C and c would be small, since owners of such funds have clout in India and the cost of managing funds would drop sharply with the amount taken out. If this assumption is made, the return on funds taken out of the country would be
R ≥ ri ≥ rl. (1−t) – cc.
Since in India, the average rate of return from business (rl) has been high, R would also be high – and likely to be much larger than the US Treasury rate, an assumption made in DK.
The BOP account consists of the capital and current accounts. In India,
A. Current Account is the sum of Trade Balance and Invisibles
A.1. Trade Account balance is the difference between Exports and Imports
A.2. Invisibles comprise Foreign Travel, Transportation, Insurance, Investment Income, Government not included elsewhere, Miscellaneous, Transfers official and Transfers private.
B. Capital Account is the sum of Foreign Investments, Loans, Banking, Rupee Debt Service and Other Capital.
Any surplus/deficit in the BOP account results in accrual/depletion of the country’s foreign exchange reserves.
Illegal flows and the underlying mechanisms
Most of the elements of the BOP have both an illegal and a legal/official component as suggested in equation (1) above. Some of the key illegal components are presented below:
A.1.a. In trade in goods and services, either mispricing or misclassification are used at times to siphon profits out of the country. Mispricing involves declaring a higher or a lower price than that actually charged by the seller by manipulating the price shown on the invoice. Misclassification involves declaring the product to be something else of a different value. The difference between the actual price and that shown in the documents accrues outside the country constitutes profit held abroad. The connivance of customs officials – and, at times, of banking channels – is essential for this process.
Exports from India are under-invoiced to take capital out of the country. The owners of the business indulging in this practice may have an overseas company for this purpose. This foreign-registered company may be operated by relatives or other trusted people. Often, such companies are registered in tax havens so as to minimize tax liability.
Imports into India may be over-invoiced to take capital out of the country. The difference between the actual price and the declared price is kept abroad. Under-invoicing of imported goods may be used to take advantage of lower duties. This is often done by misclassifying the goods. In this case, the entity from which the import originates is paid the extra amount out of the funds lying abroad. Thus, the actual value of trade in goods and services is not recorded, the official data are falsified in relation to the extent of mispricing and the result is flight of capital.
A.1.b. Trade in some items is banned and they are either brought into the country or taken out of the country illegally. This is referred to as smuggling. It can also be considered as a special case of mispricing where the declared price is zero. The entire value of the smuggled export accrues to the exporter abroad and the entire value of smuggled import is paid out of savings held abroad. For instance, narcotic drugs, human trafficking, prints of feature films, software, jewellery and so on may be smuggled out of the country. Electronic items, arms, gold, gems and so on are smuggled into the country. Both kinds of activity result in inaccuracies in the official data on exports and imports.
A.1.c. A third category of trade mispricing is the transfer pricing practiced by multinational companies (MNCs). They export goods at prices that are lower than the international price to their associate companies in other nations (including those companies registered in tax havens) where the tax rates are lower, so that the profits are transferred from one company to the other. Many MNCs also import inputs and capital from companies (associated with their parent company) at higher-than-international prices, so that the difference in price becomes the extra profit of the parent company. This also constitutes flight of capital and distorts the official data.
A.2.1 Travellers often do not indicate their actual expenses during foreign travel. Indians going abroad do not declare their actual income from the work they do there and make expenditures out of these undeclared incomes. Similarly, they may spend funds they obtain from relatives and friends for which they pay them in India. Thus, Indian travellers’ expenses are typically higher than declared. Travellers coming to India also do not always declare the full amount of money they spend, because they do not always exchange their currency in official outlets, but rather use the kerb market.
In both cases, the nation loses foreign exchange that could have come to the Central Bank. The net amount of money spent in India by foreign travellers may appear to be unaffected by these illegal transactions; however, those travelling from India to foreign countries and spending money there may be well-off Indians, while the foreign travellers may largely be less well-off. Thus, Indians’ illegal spending abroad may be higher than foreigners’ illegal spending in India. This may or may not constitute capital flight, since it may be financed by other illegal flows abroad.
A.2.2 In the case of transportation and insurance, there is illegality in relation to the rates charged. Under- and over-invoicing and misclassification of goods have an impact on transportation of goods. In certain cases ships have been lost on high seas with misclassified cargo and insurance claimed. All these result in profits being earned abroad and lead to flight of capital.
A.2.3 Investment income is under-declared in relation to the extent of illegal capital held abroad, and a return is earned on it. As the level of capital stock abroad has risen, this amount has become substantial.
A.2.4 Indians are increasingly sending their children abroad to study or going overseas for medical reasons. In many of these cases, the expenditures come from funds lying abroad or are found through borrowing from friends or relatives, with an equivalent amount paid in India in rupees. When funds lying abroad are used, it constitutes consumption from the black incomes earned there. In the other case, where funds are borrowed, there is a flight of capital from the country, since savings in India are handed to foreigners and equivalent funds obtained abroad. However, in either case, the funds are consumed and do not earn a return.
A.2.5 After the oil shock of 1973, there was an economic boom in the petroleum-exporting countries in the Middle East. This led to a surge in economic activity and a shortage of skilled labourers, such as carpenters, drivers, engineers and teachers. Skilled labourers went from India to these countries and repatriated their savings to their families in India. Kerala was a major beneficiary of this inward remittance. Havala operators quickly moved in and started offering their services to these migrants: they would take the foreign exchange and, in turn, their correspondents in India would pay the families in rupees. Until the early 1990s, there were restrictions on movements of foreign exchange, so there was a premium on foreign currency. Since the havala operator paid the premium on money sent through him, the amount of money received by the families was much greater than what they would have got through official transfer of funds. The service was quick and efficient, with money transferred immediately and without official paperwork. This activity has increased over time and is available all over the world, even though the unofficial premium is almost negligible.
The implication of this activity is that official remittances are much less than they could be. Indians who want to take their savings abroad illegally pay the havala operators in India in rupees and get the equivalent amount in foreign exchange abroad. Thus savings get transferred through this route and it constitutes flight of capital.
B.1 All the above illegal flows resulting in accumulation of capital abroad result in foreign investment by Indians. What is not declared in the current account, however, is also not declared in the capital account.
This signifies the basic fallacy in the World Bank Residual Model used in DK to estimate the flight of capital from a country. In that model, the funds flowing into the country through the capital account are compared with the current-account balance and the change in reserves. The difference between the two is taken to be the extent of capital flight, namely,
Both the capital and the current-account balances are affected equally by many cases of illegal flows, as pointed out above, and are therefore, not included in the equation. For instance, havala operators channelling the workers’ remittances imply that the official CA deficit is higher than it could have been. But since someone is taking money abroad and holding it there, the implication is that the level of external debt stated in official data is higher than it actually is. Because the two are subtracted, both the flows are missed out. Hence the use of the formula shown in equation (5) with official data misses out both these elements and, therefore, gives a lower gross figure of illegal flow of funds.
B.2 Loans are also provided from the illegal funds held abroad and therefore do not enter the official accounts, so this item of the capital account is underestimated.
B.3 Banking is the big lacunae in the capital account. Its secrecy enables illegal flows to take place. MNC banks help in illegal flows, especially to tax havens. They have subsidiaries in tax havens and are known to help their high net-worth depositors to move their funds around. In many cases of illegal trade, payments are made through banks; their help is essential in the illegal transfer of funds. In the case of legal trade, again, if money is to be siphoned out, the help of banks is essential.
In addition to the legal banking system’s help with the illegal flow of funds, there is the aforementioned illegal banking system known as havala. This has national as well as international reach. Funds can be transferred out of India as well as brought back into the country. Only the net amount of funds is needed to move from India or into India. FII flows via tax havens, and in particular the use of the PN route, have been an important source of reverse flows of capital back to India. To understand these aspects, it is important to explain the roles played by FII flows, MNC banks, stock markets and tax havens. These are presented later in the chapter.
B.4 While rupee trade no longer exists, up to the end of the 1980s, it was a source of considerable amount of corruption and illegal flow of funds.
In conclusion, one can say that every aspect of the BOP is affected by illegal flows from the country or back into it. Each of these illegal flows has a link with the Indian economy and impacts it in a variety of ways. Some of the important effects are presented later in this chapter.
The role of tax havens and ‘Swiss banks’ in flight of capital
Tax havens are entities which play the twin roles of maintaining secrecy, so that illegal transactions are hidden from the investigative agencies trying to track illegal activities and illegal flow of funds, and levying low tax rates, so that even profits generated through legal activities in other countries may be siphoned out and deposited in the financial institutions in these jurisdictions. Tax havens may be nations, such as Singapore, Dubai, Malaysia, Austria or Switzerland; small principalities such as Liechtenstein; or offshore islands under the jurisdiction of large nations, such as Jersey, the Cayman Islands or Delaware in the USA.
Profits/illegal funds are directly or indirectly transferred to these entities through shell companies to hide the true identity of their owner. Shell companies are registered for a small cost in these jurisdictions by either a tax lawyer or a chartered accountant. Often they consist of nothing but a postal address. Thousands of companies may be registered at a single address.
The purpose of these shell companies is to receive funds and then transfer them to another shell company, possibly in another jurisdiction. Once the transfer is affected, the first shell company is closed down. The money is then transferred again to another shell company, and the second company closed. Up to six transfers are carried out in this way, so the trail may be lost by investigative agencies. That is precisely what happened in the case of the Bofors money (http://en.wikipedia.org/wiki/Bofors_scandal), where the trail dried up after AE Services and Lotus. This process is called layering.
Ultimately, the money ends up in ‘Swiss’ banks under the name of some fictitious entity, or goes into some financial instrument where the real beneficiary is not known up front. The ‘Swiss bank’ is a generic category of bank, not necessarily in Switzerland, characterized by maintenance of secrecy regarding deposits made with them. While most banks maintain secrecy about their clients, these banks ask few questions about the source of the money and actively help their clients to receive and invest the money – whether legal or illegal. They may also offer numbered accounts for which no name is mentioned. This makes it difficult for nations’ official agencies when they are trying to track money deposited by their nationals. For instance, in 2007, the US discovered that 54,000 of its citizens have accounts with the UBS Bank of Switzerland.
The jurisdictions in which such banks operate argue that their banks are not obliged to give information about a client unless it can be proved that their money has been obtained by criminal means. Foreign governments’ attempts to get information about these accounts are known as ‘fishing’, since the secrecy surrounding the accounts means no details can be provided. National agencies do not know whose name an account is held in or who the real beneficiaries of the account are. They do not know how much money is held in an account or the activity through which that money was earned. Hence they can only be successful in their attempts if they get specific information by other means.
Recently, this happened through the theft of banking data. One Mr Kleibe, of Liechtenstein’s LGT bank, sold to the German government, for four million euros, a disc containing data regarding nationals of various countries who held accounts with the LGT bank. The US, Britain, France and Germany have all used this information to prosecute their nationals with LGT bank accounts. India did not initially take the data, which was offered to it at no cost; however, after pressure from the Courts, it took the data in 2009. France received stolen data from a branch of the HSBC bank in Switzerland and also shared it with other countries, including India. Apparently, the income tax department has been prosecuting Indian citizens whose names could be identified from this. A Swiss banker, Mr Elmer, has given data regarding secret bank accounts in Switzerland to Wikileaks’ Julian Assange. As a result, Mr Elmer was jailed; Mr Assange has not proceeded with the release of the data, lest Mr. Elmer gets into further trouble with the Swiss authorities.
The lesson is clear: the relevant information is held by the Indian entities who have taken capital out of the country and the havala operators and bankers who help them in this activity, and they must be caught for this information to be found. Intelligence agencies must take a greater role in collecting and using the data they have to prosecute the corrupt. For instance, the police and intelligence agencies know where havala operators work in various Indian cities, but the political will to act against them does not exist, since those in power and their associates in business use these channels to take money out of the country. In the Jain havala case in 1991, the names of some top politicians emerged; some of them even admitted that they received money through this channel. Yet no one was prosecuted.
In the late 1990s, the government created the Mauritius route to enable the return of capital that had earlier been illegally taken out of India, ostensibly for investment. Soon, 40 per cent of foreign investment was coming in through this route. Since Mauritius is a tax haven and has a double taxation avoidance treaty with India, money brought in through this route is not subject to tax. Thus, it is like an amnesty scheme for those who hold black money abroad and want to bring a part of it back.
Illegal flows and flight of capital
Since DK’s estimate of illicit flows is based on a very incomplete list of these flows, an attempt has been made below to identify the elements that are missing from it.
- A major lacunae in the definition of illicit flows used by DK, based on the World Bank Residual Model, is that there is netting out of the capital and the current accounts. While this may be acceptable for legal trade, it would not be correct for illegal flows, which have to be added to get the gross figure.
- The DK estimate takes into account the trade in goods but not in services, as mentioned earlier in point A.1.a. This needs to be added. Since it is easier to misinvoice services here, the illegal flows may be greater in this area than in the case of goods. While the IMF data on this is not available, one can apply the same ratio to the volume of services traded as to that obtained from the mispricing of goods. Further, since the IMF model refers to trade amongst a select group of countries, it does not capture the full extent of trade. A correction for this needs to be applied by applying the same ratio of mispricing to the volume of trade with the group of countries not included in the IMF list. In fact, since the IMF group consists of the larger economies, it would cover most of the trade in goods. Further, the monitoring of this trade is likely to be carried out more carefully here than it is in relation to the other countries. Thus, one will get a conservative estimate of these two elements of mispricing.
- One can assume that goods that are banned (see point A.1.b) in one country are not necessarily banned in the partner country, so the mispricing model will capture even banned items. For instance, in the case of gold, the World Gold Council data captures the amount of gold smuggled into India. But information regarding goods that are banned in both countries, such as narcotics, illegal arms and trafficked humans, will not be captured. These items will have to be added separately on the basis of the scattered data available globally.
- To the extent that gold, gems, arms and so on are smuggled into the country, illegal capital held abroad is reduced and is not available for return to India.
- The transfer pricing (see section A.1.c.) practised by MNCs may also be captured in the IMF partner-country data and may not need to be added separately. It should be noted that this amount is not readily available to be brought back to the country.
- Traveller’s expenses (A.2.1) that are not already shown must be added. To find the gross figures, estimates of under-reporting both by Indians abroad and by foreigners in India need to be added and not netted. Since these sums are spent, they do not add to the stock of capital kept abroad and cannot be brought back into the country.
- In the case of transportation and insurance (A.2.2), again, the estimates obtained must be added, not subtracted, as in the World Bank model used in DK.
- The estimate of under-declared investment income (see point A.2.3) also needs to be added. However, this must be calculated on the net amount of savings held abroad to obtain an estimate of the illegal flows. If the opportunity cost is to be calculated, however, then the gross amount of capital flow would have to be used. Further, a more realistic rate of return may be used rather than the US Treasury rate. As suggested in the earlier discussion, returns to business in India may be a better proxy; for that purpose, one may use the bank rate of lending to businesses in India.
- Illegal consumption expenditures by Indians abroad, such as when sending their children abroad to study, going abroad for medical reasons (see point A.2.4) or for tourism or purchasing luxury goods and services, reduces the stock of capital held abroad illegally. There will be two components of this. The first will be the person’s own savings abroad which are spent. This will not add to the illicit flows. However, if these savings are obtained from friends and associates or through havala, then this needs to be added. But it must be noted that this part of the illicit flows will not be available for returning to the country.
- Workers’ repatriation of funds to their families in India through havala channels (see point A.2.5) must be estimated and added to the illicit flows. To do this, one may try to estimate the excess consumption by families in states which receive a major amount of such remittance (say, Kerala and Punjab) and use that as a proxy for the total such flows.
- For illegal capital movements, as discussed earlier in this essay, there is a need to estimate the misuse of legal banking channels and the use of illegal channels (havala). In this case, there may be a strong focus on flows to tax havens. Some of these flows may have a matching flow in the above nine categories, and therefore may not add to the capital flight; however, to calculate the gross flow of capital, these would be needed.
The policy implications from the above analysis are that all of the above factors would have to be estimated in order to get a picture of the illegal flows. However, this total would not indicate the amount of capital lying abroad which can be brought back to the country. The figure obtained would be larger than the opportunity cost of the illegal flows. This would be so because the transactions pertaining to illegal flows are a multiple of the illegal incomes generated, since funds are transferred in a round-about way (for instance, in the case of layering, during transfer of funds via shell companies). Further, while estimating the illegal flows and linking them to the illegal (black) incomes generated, there should be no multiple counts of the black incomes.
The gross amount of flight of capital as the opportunity cost of capital that has gone out of the country illegally is easier to estimate than the net amount of capital flight or the actual amount of capital illegally taken out of the country and held abroad. This is because it is hard to gain figures on the return of capital and the interest/profit earned on the capital.
Macroeconomic impact of illegal flows
The implication of flight of capital is that a poor country, which is already short of capital for its development, is losing more capital. This is similar to the drain of wealth experienced during the colonial period, which set back development in India. Due to the shortage of capital, the country is woefully short of both physical (such as roads and power) and social infrastructure (such as education and health). This is especially the case since the illegal flows are linked to the black economy, which implies that the associated incomes do not pay taxes, leaving the state short of resources. This is particularly important in a poor country like India since the poor depend on the state to fulfil their basic needs, since they cannot afford to fulfil them through the much more expensive market. In other words, due to the illegal flows, poverty is aggravated and becomes entrenched in India, setting back development in the country. A total of 5 per cent of national growth is lost due to the black economy (Kumar 2005), part of which is propelled by the illegal flows.
As highlighted above, illegal flows make it easier to generate black incomes in the country and help the black economy to grow. Thus, the black economy’s negative consequences for the nation (see Kumar 1999) get aggravated due to the illegal flow of funds. Funds that go out illegally or that return back to the country have implications for macroeconomic policies. Both need to be studied separately since they may have different adverse implications, as pointed out by DK. A study of the net outflow will not give the correct picture. For instance, as pointed out in Kumar (2007), workers’ transfers of funds to their families via havala have implications for money supply in the country, and when the havala dealer gives that foreign currency to a smuggler who brings gold into the country, this activity has its own monetary consequences. These need to be separately studied. Such activities have an impact on money supply and therefore on monetary policies.
When illegal funds are brought back to the nation, they are used to further the illegal activity being carried out by that economic entity, such as in the case of drug traffickers. Returned funds may also be used in the stock market to speculate and cause a bubble to be created, which may cause uncertainty and dissuade small investors from investing in this market.
Due to illegal flows, the country’s foreign debt is higher than necessary. Similarly, the current-account deficit in BOP is higher than it need be, and this makes the country’s macroeconomic situation less stable than it could be. The economy behaves as if it has capital-account convertibility, since capital can come in and go out, but officially this cannot be taken into account in policy formulations. Thus, policies tend to fail since their assumptions are incorrect. This is also the case with many other national policies, where the existence of the black economy implies that the government is not taking into account the real picture of the economy. Finally, loss of capital implies that the country has to attract foreign capital by providing concessions, which increases the cost of such funds for the nation. This results in the weakening of the nation.
Conclusion
It has been argued in this article that illegal flows in the BOP account of a country are made up of illegal flow of goods, services, capital and finance. There are inter-linkages amongst them, but they all need to be studied for the impact that they have on the national economies. The practice of netting out to arrive at a figure of flight of capital from a country hides important aspects of illegal flows in BOP. These are important to understand the growth of illegality in the economy, the use of tax havens in flight of capital and the impact on monetary policies.
This chapter further argues that India’s macroeconomics cannot be understood without taking into account the black economy and the illegal flows associated with it. The illegal flows in a country’s BOP account adversely affect the current account of the nation. Further, illegal flows result in a loss of capital for poor countries such as India. It is akin to the drain of wealth during colonial rule. The resulting shortage of capital forces the nation to offer concessions to foreign capital (FDI and FII), which raises the cost of obtaining such funds.
It is argued that while flight of capital and illegal funds flow have been recognized for a long time, their measurement has posed problems. There has been sporadic study of this phenomenon in India, but of late, interest in this has been revived, and several reports on this activity have come out. However, this chapter points to the analytical deficiencies in these studies and suggests a framework for more detailed study which can help estimate the magnitude of the total illegal flows and the gross amount of capital flight from the country.
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